Fed teams with central banks on credit crisis

updated 9:53 p.m. ET Dec. 12, 2007

WASHINGTON - The Federal Reserve on Wednesday announced a novel approach to injecting money into the banking system as it struggles to combat a severe credit crunch that threatens to drag the country into a recession.

The announcement helped dispel the sour mood on Wall Street, where investors had pushed the Dow Jones industrial average down by 294 points on Tuesday out of disappointment with what was seen as a timid interest rate cut. After Wednesday’s announcement, stocks recouped a part of the previous day’s losses, but had lately given up their gains.

The Fed said it would conduct two auctions next week where banks can bid for up to $40 billion in loans, money that they will have to bolster their own reserves. It marked the Fed’s biggest concentrated effort to inject liquidity into the banking system since the Sept. 11, 2001, terrorist attacks.

The hope is that the extra funds will spur increased lending on the part of the banks and combat a serious credit crunch that has made loans harder to obtain for many businesses and consumers.

In afternoon trading, the Dow Jones industrial average was up more than 80 points.

The Fed linked the new auction process to an announcement that it was extending a line of credit in dollars to the European Central Bank and the national bank of Switzerland so that those institutions could better deal with credit problems in Europe. The Fed said it was also coordinating with the central banks of England and Canada.

The efforts seek to restore market confidence that Federal Reserve Chairman Ben Bernanke and his colleagues at the Fed and the monetary authorities in other countries were doing enough to deal with the spreading global credit crisis.

Private analysts expressed approval of the Fed’s efforts, saying they marked a much better response following what they viewed as a botched rate cut announcement on Tuesday. The rate cut was widely seen as not bold enough in light of the serious problems facing the economy.

“They are trying to help hard-pressed banks raise much-needed cash. The banking system is under severe pressure because the banks don’t want to lend to each other,” said Mark Zandi, chief economist at Moody’s Economy.com.

The Fed’s new program will begin with two auctions next week and another two in January. The first auction for up to $20 billion will occur on Dec. 17, followed by a Dec. 20 auction for another $20 billion.

The Fed is trying the auction program as an experiment to provide another avenue for providing loans to banks because banks have shied away from borrowing from the Fed’s discount window because of the stigma that can be linked to banks who make frequent use of it.

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